MODULE 1

The Economic Way of Thinking

Learning Objectives

At the end of this chapter, the student should be able to:

1. explain the concepts of economics and the economy;

Economics is a social science that has evolved through the years. It encompasses behavior, health,
policies, finance, and businesses. In fact, this subject is now integrated in the licensure examination for
Certified Public Accountants and has always Been a topic in the Board Licensure Examination for
Professional Teachers. Topics on the economy are always heard in the news and in other forms of social
media. We might have also heard of people or economists who discuss the economic growth and
development of the country and explain that this will affect the majority of its citizens in general. In
addition, we might have heard some newscasters report on the inflation rate of the country and mention
how the Central Bank would regulate this increase in prices. Moreover, news on how the government
will reduce the unemployment rate of the country and boost our expenditure and investments may have
also been mentioned. If we are to ask people about their definition of an economy, we may receive
various responses. This is because the word "economy" is observed among every area of business, news,
advertisement, and even in medicine and psychology. Products that are said to have items in deluxe,
premium, and economy, or that buying a certain product is economically viable are some scenarios that
use the word economy. Some people might even say that the word economy is bad because it is often
juxtaposed by crisis and poverty.

In this textbook, we shall define economy by its use in the economic parlance: an organizational
mechanism by which goods and services are produced, sold, and bought in a country or region.
Meanwhile, economics is understood as the study of how society manages its scarce resources. In the
book by McConnell and Brue, they say that...realistically, our economic wants for exceed the productive
capacity of our limited or scarce resources. So complete satisfaction of wants is impossible... (McConnell
& Brue, 2007). Now, how shall we live in a world where all the wants of the people are unlimited? This is
exactly the reason why we study economics. As a social science, economics is concerned with the
efficient or effective allocation of scarce resources to achieve maximum satisfaction or wants. There are
four highlighted words in this definition to avoid confusion in describing the subject matter. To have an
intuitive knowledge about economics, we have to answer four basic questions:

1. Is economics a science?

2. How do economists allocate resources?

3. What is scarcity?

4. Is it possible to achieve maximum satisfaction or

Is Economics a Science?

Some say that economics is a science. However, defining economics as a science, which is a systematized
body of knowledge based on facts, might be confusing as people often incorporate science as a natural
science. By confining its definition as a natural science, it shall mostly concern itself with the natural
phenomena that exist in different areas. Examples include combining two hydrogen and one oxygen to
form H₂O, also known as water; or applying the law of gravity, which provides that whatever goes up
must go down; or that an average person's tongue could not reach the tip of his/her nose. Natural
science, however, deals more with controlled variables. In natural science, facts apply to all. Let us take
the law of gravity as an example: if a person jumped and he/she did not come back to the ground,
different weird thoughts may enter your mind, like that person may actually be a ghost or some kind of a
superhero. Meanwhile, social science deals with the human society and an individual's role in the
society. Social scientists view a person as a whole and will mean different assumptions to ascertain a
fact. For example, the law of demand states that if price increases, quantity demand will decrease,
assuming all factors are constant (also known as ceteris paribus). Why is it very important to place the
word ceteris paribus in this definition? In the absence of such term, it shall mean that a commodity will
instantly result in a lower quantity demanded if you just increase its price. However, this is not
completely true as there are different factors that may affect quantity demand other than price. We will
discuss this further in the succeeding chapters of the textbook. The bottom line is that social science
deals with uncontrolled variables. Moreover, we can say that the human society or the market in general
has a different incentive pattern. This means that there are many commodities, and that even though
their prices decrease significantly, the demand for those commodities may remain low and a social
scientist will have more considerations that will explain why such scenario exists. Hence, we ask: Is
economics a science? The answer is in the positive. To be accurate, economics is a branch of social
science.

How Do Economists Allocate Resources?

Because economics is concerned with the efficient or effective allocation of resources, there is a need to
emphasize the words efficient and effective because these words are often misinterpreted as one and
the same. Efficiency means attaining maximum output with the least possible input. Input does not only
refer to money, but it may also refer to other variables, such as raw materials, time, and effort that a firm
needs to produce a certain commodity. Output, meanwhile, is the result or the final product in a
production. Effectiveness can be attained by getting the desired outcome. For example, a clothing firm
needs to produce 1,000 pieces of polo every month to maintain its target market. If the firm reaches that
target with its current number of employees (15 sewers), and assuming all other factors are met, it
means that its employees are effective. Conversely, if 15 sewers can make around 1,250 pieces of polo
with the same number of resources, then they are efficient, as they can maximize their output with
fewer inputs. Thus, economists can either allocate efficiently or effectively, depending on the
circumstances

What Is Scarcity?

Scarcity is the condition where wants and needs of people are not satisfied because of limited resources.
Equally, the law of scarcity provides that resources are limited for the unlimited wants of man. Scarcity is
one of the main reasons why economics exists, acknowledging the fact that resources, such as time,
labor, and the like, are limited; hence, we have to use them wisely. Contrary to the common definition of
scarcity online, scarcity is not the same with shortage. The word shortage is a temporary condition
where the demand on a certain commodity or service cannot be met by the current supply. This means
that after a certain period, shortage can be resolved. This is done by increasing the production of the
commodity or by training more people in producing a certain service. Although there are some
commodities that require longer period to be supplied, these can still be met after a given time.
Scarcity, meanwhile, is a perpetual condition that economists always need to solve because our wants,
needs, and satisfaction are unlimited, and yet our resources are limited. For example, many people in
Metro Manila complain about the crowded and inconvenient train stations (LRT 1 and 2, and MRT) in the
country. The response of the government is to increase the price of the train stations' fare, so that it will
have additional budget for the development of the stations. However, majority of the people will not
approve the said proposal because it will affect their purchasing power, given that this type of
transportation forms part of their everyday expenses. In this situation, we see that government
resources are limited, but people would want the government to provide a solution that will not
inconvenience them. This is the reason why the government should make choices where compromise
will be made with some sectors, or respond to the want of the people immediately, thereby prioritizing a
certain sector (in this case, transportation) before allocating its resources to the issues of the other
sectors in our country.

Is it possible to achieve maximum satisfaction or wants?

The answer is very simple: If all things are managed well, we can achieve maximum satisfaction or want.
This is one of the reasons why economics exists. All throughout the textbook, the author will give you an
idea on the things that exist in normal business firms, including a situational analysis of countries, and
help you analyze how these things can cater to the maximization of human wants and needs. To
understand how an economist exerts an effort to the maximization of human wants, it is necessary to
understand how he/she thinks by applying the Economic Way of Thinking.

The Economic Way of Thinking

There are many ways to depict how economists think, but this textbook would opt to describe it in three
applicable ways: (1) decision-making during scarcity; (2) rational behavior; and (3) marginal analysis.

In a world of scarcity, most of the things we do would require us to make choices.

Because resources are limited, decision makers should decide what to have and what to forgo. This is the
reason why we hear an economist say, "There is no such thing as free lunch." The idea is simple: you may
get treated to lunch by a person, so it is "free" for you, but it will be a cost to someone else-up to the
extent that it could also affect the society. How can one free lunch affect the society? Let us look at one
particular meal-a dinner. During the time of President Gloria Macapagal-Arroyo, she and her team went
to New York to strengthen international relations. Their dinner at that time was worth around $20,000,
and apparently, people would say that such amount could be used on other development projects that
can help more people. However, one thing that people fail to recognize is that our president was there
establishing international relations, which could be more sustainable in the long run. The meal might
have cost the country $20,000, but the help from the international community to the country could even
be twice or even 50 times more than said amount. Some people may not find this acceptable, but the
beauty of economics is where you receive more than one solution in a given situation.
Here is another example: the clamor for a hike in train fare in Metro Manila. According to LRT/MRT
officials, the fare should be Php 60.00 in 2013 (Bacani, 2013). However, in January 2014, the fare remains
at an average of Php 15.00. The fare difference of Php 45.00 is being shouldered by the government in
the form of a subsidy. That seems like a little amount on an individual level of looking at it, but if there is
an average of 500,000 persons taking the train every day, we could see that the government is already
paying an 8-digit subsidy just to maintain that supposedly cheap fare. Given that we have 365 days in a
year, we will arrive at a 10-digit subsidy every year. A sample computation can be seen in Table 1.1.

Table 1.1. Hypothetical Computation of Government Subsidy in One Year

Subsidy per Individual

45

Average number of people taking the LRT every day

Average amount of subsidy every day

22,500,000

Average amount of subsidy every year

8,212,500,000

m he ns, can mist OW

Others might say that there is no problem if the government shoulders that amount of money. They
argue that this amount can be recovered from the taxes being deducted to our purchasing power.
However, we should acknowledge the fact that the government's problem does not rest on
transportation alone. They also have to respond to the needs of other sectors: health, education,
agriculture, security, and many others. Consequently, to maintain the cheap train fare right now, the
government has to get a share of the national budget so it can respond to this need. This is one of the
reasons why a fare hike has been proposed since 2012: both LRT and MRT only benefit the people
residing in Metro Manila, and yet the said utility is getting a portion of what is due for the other parts of
the nation. This means that other people in the country are sacrificing a portion of their income to
maintain the cheap fare. This is why the government wants to balance the situation, but others do not
approve of such contention because it would hurt their daily expenses.

opt onal

and thing free Et the eal-a went worth ed on people which

Economists call these sacrifices opportunity cost. Opportunity cost is the cost we forgo to getting
something else. The cost of that which you get is the value of which is sacrificed to obtain it. This could
be best depicted by the production possibilities frontier (PPF). The PPF represents points at which an
economy is most efficiently producing its goods and services, limiting the economy on two commodities.
Figure 1.1 shows points where a hypothetical economy is allocating its resources in the best possible
way. If the economy is not producing the quantities in line or not on the PPF points, resources are being
managed inefficiently. The PPF shows that there are limits to production; therefore, for an economy to
achieve efficiency, it must decide what combination of goods and services to produce. Figure 1.1 shows
this economic fact.

Rational Behavior

In economics, one of the assumptions we always acknowledge is that human behavior reflects "rational
self-interest." Individuals would always find a way to increase their utility. Utility in economics is an
individual's pleasure, happiness, or satisfaction. These are the things where we have allocated our time,
money, energy, and other resources to maximize our well-being. In a very vast society, some people
might be happy reading inspirational books, while others are happy playing.computer games. Other
people may be satisfied working hard to achieve a physically fit body, and others would just love to treat
themselves to desserts at home. Whatever makes a person happy and satisfied gives him/her a specific
utility. This makes the analysis of a society a little bit more complicated because by definition, rational
behavior means that the same person may make different choices under different circumstances. As we
may have observed, there are times when we do not feel like buying a certain item, but because there is
a salesperson convincing us that we need to purchase it, we find ourselves leaving the mall holding a bag
of whatever that person sold to us. In reality, there are thousands of reasons why we buy a certain
object for our households. Reasons may include personal hygiene, a need to use something for one's
kitchen, to look better than others, and other personal motivations to purchase. This is the reason why
we should have different assumptions when analyzing a subject matter. As there are different things that
may satisfy the wants of individuals, we will limit this on some grounds by making some assumptions to
make these things valid.

Marginal Analysis

In essence, before we choose a certain alternative, we often ask ourselves if this will be "beneficial or
not" or "should we pursue this action or not." In the economic perspective, these questions are also
asked, but they are often answered in a unique way by using an approach we call marginal analysis or
comparing the marginal cost and marginal benefits. The word marginal means additional, change in, or
add in. This means that before a certain action is made, economists would look at how it may affect the
firm at the margin. To understand this further, let us look at Table 1.2.

Table 1.2. Hypothetical Output of a Farm

Number of employees

4
5

Number of output produced

50

60

71

76

77

Marginal productivity

10

11

Here we can see that when the number of employees changed from one to two, the additional benefit of
the firm is 10. It increases by 11 when the employees are already three, but slowly declines as it reaches
four to five. This means that this hypothetical
Basic Circular Flow

in economics, most of the analysis starts with the basic circular flow. It showm the interdependence of
two entities in the economy: households and firms. The model describes the flow of money and
products throughout the economy in a simplified way. This model represents all of the factors in an
economy as either households or firms, and it divides markets into two categories: (1) markets for goods
and services (produtt market), and (2) markets for factors of production (factor market). These can be
seen in Figure 1.3.

Spending P (=GDP)

Product Markets

Revenues (GDP)

de and Services Purchased

Goods and Services Bald

Households

Flow of Money

Labor Land Capa Entrepreneurship

Inputs for Production

Business Sector

Income ($) (GDP)

Factor Markets

Wages, Rent, Interest, and Profit

Figure 1.3. The Basic Circular Flow

We can see that households have four factors in the market, and these are land, lobor, capital, and
entrepreneurship. These four factors will become inputs of production to the firm. The output will be the
goods and services sold on the product market, which can be purchased by the household again. This
cycle is repeated. In return, firms give factors of payments in the following inputs of production:

rent for the land

✓ wages for the labor

✔Interest for capital

profit for entrepreneurship

These will be the income of the people of the household, which they could spend on the product
market. The goods and services purchased and spent by the household will be the revenue of the firms,
which can then be allocated again on the factors of payments, which are rent, wages, interest, and profit,
and the cycle goes on.

10

MANAGERIAL ECONOMICS IN THE 21ST CENTURY